One of the design characteristics of being human is that we run from fear, we protect ourselves from danger, from bad things – whatever it may be. Whether it’s an animal in the woods, or a scary dark room, an emotional response goes off in our brain. To run. To protect. After all, the word emotion stems from the Latin root meaning “to move away.”
Before we judge ourselves and judge others we need to understand that we are human. Therefore, we aren’t perfect and are designed with flaws in certain situations and circumstances. Before we imagine ourselves acting in a certain way in a hypothetical situation we need to understand this basic truth.
It is October, Halloween is approaching. It is haunted house season. We know that haunted houses are not real. We know that things are going to jump out of dark places. We know almost exactly how it is going to play out. But we still get scared.
There are countless examples of situations like this where we know the outcome, or know the situation, yet we still react a certain way. Fortunately or unfortunately, depending on the situation, this is by design.
Knowing something is one thing, acting human is another.
This is how behavioral finance works.
If an advisor asks clients about how they will respond to a 30% drop in their portfolio, many times they may get the “right” answer. “I will stay the course and not react.” “I will continue adding to my portfolio.” “I will add even more to my portfolio, buy at a discount right?”
The reality is, this is not how humans respond. This isn’t how we are designed to respond to fear. Responding properly to the hypothetical is only the first line of defense. A high majority of investors will not actually act this way when the time comes because it is much easier said than done. Just like remaining calm in a haunted house or during a scary movie is easier said than done.
Most people couldn’t imagine sitting through the scariest of movies and not flinching. But we do imagine ourselves having zero reaction to a market crash.
Markets go up and markets go down. They always will. We know this.
However, when markets fall, every news headline is negative, every social media post is negative, thousands of “experts” are calling for the end of the world as we know it. Fear sells. During market turbulence this fear selling happens for days and weeks and months on end. All of this noise penetrates well beyond our first line of defense and gets to our 2nd, 3rd, and 4th layers of defense.
When all of your friends, neighbors, and co-workers are telling you to sell. Or telling you that they sold everything last week and that you should too. This gets to our 5th and 6th layers of defense.
We know that reacting during a volatile or falling stock market is not likely to turn out well, but sometimes we cannot resist the urge to do what we’re designed to do. To do something.
How hard would it be to do nothing? How many layers of defense do you have? After all, we’re only human.